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Baby boomers may have temporarily soured on equities, but a solid case for higher inflation will get their attention

Some 20 years ago, financial editor and writer Joe Nocera (now an op-ed columnist for The New York Times and author of “All the Devils Are Here”) explained to a group of us editors at Worth Magazine why our baby boom generation had gotten a bad rap for being such profligate spenders: “We grew up during the 1970s, when double-digit inflation was the norm. Holding cash when money was losing 10% or more of its value every year made no more sense than putting your money in a bank in the 1930s (when many banks failed, taking their depositors’ pre-FDIC insured savings with them) did for our parents or grandparents.”

I was once again reminded of Nocera’s comment in a conversation with Scott Colyer, CEO of Advisors Asset Management in Monument, Colo., a firm that provides fixed income solutions, monitoring, education and industry-leading hand-holding services to independent advisors: “The general population has not dealt with a bear market in fixed income.” Colyer also said that baby boomers lived through the debt-fueled bull stock market from 1982 to 2000 (when the S&P 500 climbed from 112 to 1,499), but the following Generation X largely came of financial age between the dot-com crash of 2000, and the mortgage meltdown of 2007 and 2008 and its aftermath, rendering virtually the whole 10 years a “Lost Decade” for many retail investors.

The point is that investors are, more often than not, a product of their experience: People who lived through the 1930s learned not to trust banks or stock markets, and consequently tended to believe in FDR’s New Deal and a much bigger government (including Social Security) to protect them. The parents of us baby boomers made fortunes in the booming stock markets of the ‘50s and ‘60s, and their residential real estate, which in many places saw five-fold or greater increases in value (people didn’t move around much back then). Consequently, they were big believers in the American Dream. Meanwhile, we baby boomers had our bull market experiences erased by the Lost Decade. Boomers and the Gen Xers, who never had those fond memories, both watched as our retirement portfolios lost half or more of their values and only recently crawled back to break even, if that.

As a result of the ongoing financial turmoil, many of today’s investors have lost faith in the stock market and the financial institutions that they believe manipulate it. This is both good and bad for independent advisors. On the bright side, independent firms are adding new clients in numbers not seen since the tax-shelter days of the early ‘80s. The other side to that coin is that these new clients are more risk averse than clients have been any time since the go-go market crash of 1969 (which motivated Bruce Bent at the Reserve Fund to invent money market funds, giving those fearful investors a place to park their money on the sidelines). As a result, they either want to keep their money in cash equivalents or put it into bonds—neither of which seem likely to enable them to reach their financial goals or meet their financial obligations. The professional challenge for today’s advisors is to find a way to talk their clients down from their own fiscal cliffs.

The current problem with bonds is that they represent another facet of the baby boom and Gen X experience—albeit one that’s rarely talked about. Ignacio Pedrosa, head of institutional investors for EDM Asset Management, an investment firm based in Spain, wrote in an Instablog published by SeekingAlpha.com on Dec. 17: “Since 1981, American treasury bonds have increased virtually without interruption and offered a spectacular annual return: 12.6% in the 1980s, 8.8% in the 1990s, 7.7% in the previous decade, and 20% in this decade so far. Accordingly, government bonds during the last 30 years have been considered to be risk-free assets. […] Investors in government debt securities have been used to holding assets with low volatility, which, in addition to paying a coupon, always increase and maintain their price.”

With their confidence lost in equities (which ironically have posted handsome returns in recent years), investors and their advisors have increasingly turned to bond funds. “Since 2008, investors in the U.S. alone have invested $1.1 billion in [bond funds],” continued Pedrosa. “At the same time, [equity funds] have suffered redemptions of [$400 million]. In other words, more than double the amount redeemed in equity funds was virtually invested in fixed-income funds.”

Of course, the question that most of today’s investors fail to ask—and therefore rely on their advisors to raise, whether they want to hear it or not—is how long the bond market can continue to deliver these stellar returns. Rather than the result of an economic boom and investors scrambling to participate in it, the current bull market for bonds has been artificially created by the Federal Reserve, as it quantitatively eased interest rates down to essentially zero (the value of bonds naturally goes up when new bonds with lower coupon rates are issued). However, if and when it does, those low-interest bonds will suddenly become a lot more risky. Colyer at Advisors Asset Management put it succinctly: “Bonds are more popular today than in 1999. That sounds like a market top.”

Pedrosa was more expansive: “We must not forget that the primary mandate of the central banks is to control inflation. As soon as any inflation rears its head, the bonds will begin their downturn. If the yield of long-term debt returns to its historical average, the price of 10-year American bonds will depreciate by 26%. In the most extreme case, such as that experienced in the 1980s, the price of the 30-year bond would fall by 80%. The last time the American T-Bond was traded at current levels was 1946. Its return over the next 30 years was negative in real terms: For the following three decades, bond investors lost purchasing power.”

AdvisorOne.com’s Mike Patton is equally concerned about looming inflation and the higher interest rates that would come with it. In a blog published on Dec. 24, he wrote: “Today, the most disconcerting issue to me is the reckless fiscal path on which we are traveling. America is amassing debt at an alarming rate. Moreover, with the Fed functioning as the chief supplier of capital, there is theoretically no limit to the amount of debt we can amass. Of course, unabated money printing does have its consequences. At some point, this easy money policy could well blow up in our face, causing interest rates and inflation to spike. This is a scenario that does not end well.”

The silver lining here is that our growing national debt, and the specter of inflation and the higher interest rates that go with it, provide the basis of an investment strategy that today’s clients can readily understand. Baby boomers already understand the dangers of inflation from their childhoods, and Gen Xers have lost so much faith in financial institutions that the notion that we are propping up our current low-interest environment with smoke and mirrors will be no great revelation.

For those advisors who prefer a broader strategy than simply “equities seem poised for a rally once interest rates start up,” there are ways that fund managers and advisors can manage the risk inherent in bonds. “We teach advisors to be smarter bond investors,” said AAM’s Scott Colyer. “For clients who need, or simply demand, bond exposure, we suggest moving up the yield curve to better protect principle; shortening duration; and using laddering strategies to diversify risk and to take advantage of rising interest rates.”

Mike Patton suggests two other possibilities: “Emerging market bonds should continue to do well as their central banks reduce rates. Also, it appears real estate has bottomed and a good quality real estate fund may be warranted.”